Fixed Income

Over the past six months interest rate markets have seen extremely strong rallies globally, with the US 10-year yield falling by over 100 basis points since October 2018. Over the same time period cash rate expectations have fallen considerably in the US, with the rates market now pricing in three rate cuts in the next 12 months.

Chart 1: US cash rate and cash rate expectations 

Source: Bloomberg

Using the 2-year bond as a proxy for future cash rate expectations, we can see that these bonds are now trading almost 60 points under cash. In fixed income, this is called a ‘front end inversion’ and implies the market is strongly expecting interest rate cuts.

The simplest way to understand why this is the case is to think about an investor with a 2-year investment horizon. Today, that investor has the choice between taking the cash rate at 2.5% and rolling it over each month or locking in a rate of 1.90% for the entire period. Given these investors are willing to give up 60 points of yield to lock in that rate, they must believe that cash rates are set to fall and do not want to take the roll over risk should that occur.

Chart 2: US 2-year bond – Cash rate

Source: Bloomberg

It’s all just a little bit of history repeating

Given there are relatively few occurrences of front end inversion, this raises the question: “how often does the rates market get this much ‘conviction’ without being right?”

Since 1985, the simple answer has been never. 

In every case when the 2-year yield has fallen 50 points below the current cash rate, a Federal Reserve cutting cycle was just around the corner. 

These include the following dates of 50 points of inversion and then the subsequent rate cut:

  • May 1989 – First rate cut comes June 1989 (1 month)
  • Aug 1998 – First rate cut comes Sep 1998 (1 month)
  • Sep 2000 – First rate cut comes Jan 2001 (4 months)
  • Sep 2006 – First rate cut comes Sep 2007 (12 months)
  • May 2019

Chart 3: US 2-year bond and cash rate

Source: Bloomberg

This is a very consistent signal and if we relax the criteria to only 25 basis points under cash we would have also picked up a signal during both the 1986 and 1995 interest rate cuts, while showing no period where they actually held rates stable. So, it’s fair to say that the interest rate market really does know best.

The worry of markets

Without delving too far into the economic indicators, we can also get a feel for the types of factors that are worrying rate markets. Two of these are the declining global trade situation and the slowing in the US housing cycle.

On the trade statistics we have clearly seen a decline in trade over the past six months, with China also showing signs of slowing. If we focus on the average export growth of the world’s five largest exporters (US, China, Germany, South Korea and Japan), then we can see a clear step down from around 10% growth to 0% in November 2018

As Chart 4 below shows, this coincides with the Fed becoming more ‘patient’, as evidenced by the number of times it appeared in their Board meeting minutes. The last time the Fed really mentioned the word patient was when global trade was declining in late 2014, which extended the time frame for when the first rate hike would arrive.

Chart 4: Export volumes and Federal Reserve ‘patience’

Source: Bloomberg

The other change over the past six months is that the residential construction sector has been declining. This has coincided with the rate hikes of the past 24 months, signaling that the rate-sensitive sector of the US market is starting to become constrictive. 

Chart 5: Residential construction and rate moves

Source: Bloomberg

This should be a relatively concerning development, given the Bank of International Settlements’ research made the following statement in 2018:

Drops in residential investment consistently lead economic downturns in the 99 recessions identified in our sample… We show that information on declines in residential investment improves the performance of standard recession forecasting models that also feature the slope of the yield curve.”

Conclusion

Given the US yield curve has inverted, residential construction is declining and the global trade environment is starting to decline, the Fed should soon be thinking about rate cuts. If the differential between 2-year bonds and the cash rate is correct, then we should see a far more dovish Fed sometime over the next few months. 

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